Marshall School of Business
University of Southern California
Catalytic Solutions, Inc.
Teaching Note
Purpose of Case
The Catalytic Solutions, Inc. (CSI) case was written to motivate a class discussion about some
issues commonly related to the design of performance measurement and incentive systems in
young, growing firms. The subject firm in this case is privately held, is still in a pre-profit
situation, and is preparing itself for an IPO in, hopefully, the not-too-distant future. The case
Possible Student Assignment
As with most cases, students can be given more or less preparation guidance in their
assignments. If the instructor wants to provide relatively little guidance, we suggest this short-
form assignment:
1. Evaluate the CSI performance measurement and compensation systems. What changes
would you suggest be made to these systems, if any? Explain.
300
2. Fast-forward 10 years. Assume that CSI has been successful. It is now a much larger, public
company. It has three operating divisions (investment centers) that focus on different
markets. What would you expect the CSI measurement and compensation systems to look
like at that time? Why?
Here is a possible longer assignment:
1. Evaluate the composition of the compensation package at CSI.
a. What are the advantages and disadvantages of awarding stock options?
b. What are the advantages and disadvantages of awarding bonuses?
2. Evaluate the specific features of the annual bonus plan in 2001 and 2002. Comment on:
a. The choice of the number of measures used, the specific measures used, and the
3. As CSI grows and, perhaps, becomes a public company, how will the firms performance
measurement and compensation package choices evolve?
Discussion
A. Critical Success Factors
One good way to get into the case discussion is to clarify the companys situation. This can be
done by assembling a list of CSIs critical success factors (CSF). CSI seems to have developed a
better product, a catalytic converter with better performance at lower cost. It must maintain that
competitive advantage, and CSI managers think that they can do so.
CSI is trying to sell its product into an industry, automobile manufacturing, which is demanding
and unforgiving. There are significant barriers to entry. On the other hand, the market potential
is huge. To get market penetration, CSI managers must tell their product-superiority story
effectively, and they must show the manufacturers that they can deliver the product with
consistent high quality on schedule.
The list of CSF, then, should include the following:
Product designperformance and cost. Maintain a technological advantage.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
301
The list of CSF is complete if one can be comfortable concluding that if CSI does well in all of
these areas the company is highly likely to be successful.
If instructors have previously taught subjects like integrated performance measurement systems
B. Compensation Package
The CSI compensation package has three elements: base salary, stock options, and annual
bonus. The CSI strategy is to pay below-market salaries and then to use the other two elements
to make the total compensation competitive.
One decision that can be usefully discussed in class is CSI managers choice of the relative
importance of the three elements of compensation strategy. Why did the company choose to use
three compensation elements rather than just one, either 100% salary or 100% performance-
dependent compensation? This should lead into a discussion of the purposes of compensation
systems. These purposes include:
1. Attraction/retention of good people. Paying employees only guaranteed salaries tends to
attract risk-averse employees. Paying performance-dependent compensation tends to attract
employees who are more risk tolerant, more aggressive, more confident in their abilities,
and/or more financially independent. What kind of people does a start-up company most
want? Likely many more of the latter kind.
2. Motivation. Motivation has two elements. One involves inducing effort, getting employees
to work hard. The other is directing effort, helping employees understand what is expected
of them. In the case of CSI, the induction of effort seems not to be a problem. CSI
employees seem to be extremely hard working. But the company needs to inform and
remind employees about what is important for the company to succeed. This is a primary
purpose for the CSI bonus system.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
302
C. Stock Option Plan
The CSI compensation element that is least understandable for most students is the stock
options. Options can provide huge payoffs to employees if the company is successful. Because
their value depends on firm-wide performance, options can shape the culture of a company.
They can help create a teamwork culture and cross-functional, cross-departmental cooperation.
The options also provide compensation while conserving cash, which is often important in a
start-up company. CSI is not short of funds. But even so the companys cost of capital is high,
as much of the funding has come from venture capitalists.
The complication in this case is that CSI is a privately held company. What do stock options
mean in a privately held company? There is no market for the options until, and unless, the
company goes public, which it hopes to do in the next couple of years after the time of the case.
There is no easy way to value the CSI options. Employees can sell their options if they can find
The problem is that CSI managers are limited in what they can tell their employees about the
stock options. They are reluctant to provide an official declaration as to what the options are
worth for fear of having the employees become disappointed if those values are not
subsequently realizable. In Mike Redards words, the conundrum was, How do we
communicate the value of the options without promising that value?
D. Bonus Plan
Since the focus of the case is on performance measurement, much of the class time should
probably be spent on the bonus plan. There are many issues that might usefully be discussed.
One issue is the level of measurement. Both CSI performance-dependent compensation
elementsoptions and bonusesare based on company-wide performance, rather than the
performances of specific individuals. Company-wide measures are really controllable to a
significant extent only by a few managers at the top of the firm. But, for example,
manufacturing employees, about half of CSIs workforce, were rewarded for new OE
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
303
This makes these compensation elements wealth-sharing features, rather than motivational
features, in an effort-producing sense. The instructor can illustrate this point by discussing it in
terms of any motivational theory, such as expectancy theory or path-goal theory. For most
employees, the expectancy that an individuals behavior will accomplish the goals for which
rewards are paid is quite small, so little or no motivation is produced.
A second important issue is that involving the heavy use of non-financial measures of
performance. In 2001, the bonuses were based exclusively on non-financial measures of
performance. In 2002 financial measures were added, but their importance weighting was still
much below that of the non-financial measures. (Figure TN-1 shows a summary of the measures
and their importance weightings in 2001 and 2002.)
A third issue is the choice of measures. If CSI has chosen well, their measures should be a good
representation of their critical success factors. Students might be asked to identify factors that
are missing from the CSI lists. One that could be added would be an indication of the quality of
the product delivered to the customer, as indicated, perhaps, by customer returns. Is it necessary
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
304
it can create an unfortunate expectation that can undermine the incentive value of the incentive
awards.
The QS9000 certification example illustrates those benefits and costs. The QS-9000 bonus
award was given in 2001 even though CSI missed the target by few weeks. The danger here is
A fifth issue that can be discussed is regarding the number of measures. Compensation
consultants have several rules of thumb for choosing the number of measures to include in
bonus plans. One is that not more than 5 8 measures should be included. Five to eight
measures typically capture most of the important performance factors and including more
A sixth issue is that related to calibration of the bonus payouts. CSI managers strove for
payouts near 100% of the target bonus level if all employees worked hard and smart. CSI
managers recognized that there would be some variance between good and bad years. (If this
E. The Future
The last assignment question asks students to think about how the CSI performance measurement
and incentive systems will change. CSI managers knew that their strategic themes were
changing year by year. Here is their short list of themes for the early years:
2001
New customers
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
305
Build infrastructure
2002
New customers
2003
Grow existing base
Mike Redards guess at the strategic themes for 2013 was this list:
SBU focus
Pedagogy
As with most cases, the instructor has to decide how structured to make the class discussion. In
this case, because so many issues might be raised, some structure is probably necessary. We
suggest following the outline of the discussion, with perhaps the following time allocation in a
class of 75 minutes:
Company background and strategy 10 minutes
Compensation strategy 15 minutes
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
306
Figure TN-1
Comparison of Measures Used in the CSI Bonus Plan 2001 and 2002
(Importance weightings shown in parentheses)
2001 2002
OE commitments (41%)40 Financial (27%)